Question

Clean Chips is a manufacturer of prototype chips based in Dublin, Ireland. Next year, in 2019, Clean Chips expects to deliver 700 prototype chips at an average price of $52,000. The plant cannot produce these prototype chips annually in the plant’s current condition. To meet future demand, Clean Chips must either modernize the plant or replace it. The old equipment is fully depreciated and can be sold for $4,450,000 if the plant is replaced. If the plant is modernized, the costs to modernize it are to be capitalized and depreciated over the useful life of the updated plant. The old equipment is retained as part of the modernize alternative. The following data on the two options are available:

Modernize Replace

Initial Investment in 2019 $ 36,800,000 $ 61,700,000

Terminal Disposal Value in 2025 $ 7,000,000 $ 17,000,000

Useful Life 7 Years 7 Years

Total annual cash variable costs per chip $ 35,500 $ 26,000

Clean Chips uses straight-line depreciation, assuming zero terminal disposal value. For simplicity, we assume no change in prices or costs in future years. The investment will be made at the beginning of 2019, and all transactions thereafter occur on the last day of the year. Clean Chips’ required rate of return is 10%. Clean Chips has a special waiver on income taxes until 2026.

Required:

1. Calculate net present value of the modernize and replace alternatives.

2. Which alternative should Clean Chips choose?

3. What factors should Clean Chips consider in choosing between the alternatives?

Answer 1

ANSWER:-